Credit-Default Swap Traders Profiting from Inside Info on LBOs?

by: Judith Levy

Excerpt from our Wall Street Breakfast, a one-page summary of this morning's key market-moving and stock-moving stories:

Credit-Default Swap Traders Anticipated Announcements of LBOs [Bloomberg]

Summary: Credit Derivatives Research LLC, a New York-based independent research group, contends in a recent study that derivatives traders may be profiting from inside information on leveraged buyouts. The tip-off was the rise -- prior to the public announcement of any deals -- of credit-default swaps based on the bonds of 30 takeover targets in 2006, including four of the year's five biggest LBOs. "Evidence shows that CDS prices are widening before public rumor or news," said Tim Backshall, a strategist at Credit Derivatives Research. "Whether it's insider trading or more informed selling is unclear." Credit-default swaps are contracts derived from bonds and loans that are used to speculate on a company's ability to repay debt. They were designed ostensibly to protect bondholders from default -- they will pay the holder face value in exchange for the underlying securities if the company fails to pay its debts -- but they have proven very attractive to speculators, since they are less expensive and more liquid than corporate bonds. Since their invention less than a decade ago, the total face value of CDS contracts worldwide has reached $26 trillion -- a faster growth rate than any other derivative. The study notes that in 2005, the cost of credit-default swaps on $10 million of Knight Ridder bonds surged 35% one day before the company's largest shareholder called for a sale in an SEC filing. Credit-default swaps on $10 million of HCA Inc. bonds rose 48% in 2 1/2 months before news broke that the hospital operator was in talks for what has turned out to be a $33 billion LBO. And the week before the New York Times reported on Sept. 11 that Freescale Semiconductor may be sold for $16 billion to an investor group, credit-default swaps based on the company's bonds rose 11%. CDS traders are essentially unregulated: neither the SEC nor the Commodity Futures Trading Commission [CFTC] claims responsibility for their actions. The swaps themselves have become a research tool for analysts who monitor their trading activity as a means of keeping abreast of possible pending deals.
Related links: Credit Default Swaps: Underestimated RiskInsider Trading Based on Credit Default Swaps Persists -- Who Will Fill the Enforcement Vacuum?Insider Trading in Credit Default SwapsCan Anyone Police the Swaps?

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